Can Loeb Reinvigorate Sotheby’s?

Now that Third Point LLC’s founder and CEO, Daniel Loeb, and the board of Sotheby’s (BID) have come to an agreement, is now the time to buy the stock? There is currently an opportunity to buy it at a lower price than Loeb. He currently has 6.35 million shares valued at valued a little under $260 million. His average purchase price is $43.91 with his purchases starting in February of 2013. The stock is now trading for about 7 percent less at $40.76.

Management’s claim that 2013 was a “record” year is misleading and demonstrates the risk of having a Board asleep at the switch.

While, relative to the Company’s prior peak in 2007, the Company sold a greater dollar value of art, the more meaningful metric is that the company generated less revenue and spent more money to do so.

The bottom line is that earnings per share were down 42% versus their prior peak.

Given the global tailwinds in the marketplace, this performance is unacceptable and we believe it can be linked back to failed leadership of the Sotheby’s Board.

Failed to Seize Growth Opportunities

Sotheby’s needs to articulate a strategy and vision

Both auction and private sales growth and be accelerated with better technology, more dynamic sales techniques, and improved client relationship management, as well as more online and curated sales.

Management can deploy more capital against the profitable secured lending business

Principal and dealer activities, though small today, can be expanded significantly through partnerships with living artists, artists’ estates, and even real estate developers

Additional brand extension opportunities explored.

The agreement between Loeb and Sotheby’s is for Loeb to join the board of directors along with two of his own appointees. The board was expanded to make room for the new members. Loeb has said that the current board has become stagnant with its members having an average of nine years of service. They are also lacking “skin in the game” with the board only holding 0.87% of the outstanding common stock. Together, the new board members from Third Point own 9.64 percent of the outstanding shares.

Sotheby’s direct competitor is Christie’s, and their rivalry goes back to the 1700’s. Sotheby’s is the oldest company on the New York Stock Exchange, starting in 1774. Christie’s is currently in the lead for aggregate auction sales in the global marketplace with 53 percent of the marketplace, compared with Sotheby’s 47 percent. One of Loeb’s ideas for Sotheby’s to better compete is to increase the number of auctions of lower priced lots. Lots of $100 thousand have a 25 percent buyer’s premium compared to lots of $2.2 million having a 12 percent buyer’s premium. This strategy would increase sales and margins. Christie’s has already taken on this strategy. Chief Executive Steven Murphy said the company’s 80 collecting departments handle goods priced as low as $200. Sotheby’s mainly focuses on the wealthiest collectors avoids the lower price points.

There are many risks associated with Sotheby’s. The company is cyclical and the stock is volatile. The stock is now at the about the same price as it was back in 1999. Since then it has fallen near the $7 level twice and has reached $50 and retreated three times. Over the past couple of years the stock has had buying support at around $30, which is where the stock would likely go without the addition of Daniel Loeb (Trades, Portfolio).

The cyclical nature of the business can be seen through the stocks beta of 2.42. That means the stock tends to follow the overall trend of the markets but at a magnitude of nearly 2.5 times the strength. Lately there has been worry about the market in art coming to a top. A recent auction earlier this month had results that were near the bottom of estimates. The Sotheby’s impressionist and modern art auction resulted in 30 percent of the pieces not being sold. CNBC said that it was a level probably not seen since 2009. It will be important to keep an eye on the results of the contemporary art auction coming up on May 14th. There will be many big names represented, including Warhol, Koons, Basquiat, and Pollock. A goal listed by Loeb is to formulate a strategy to manage the inherent cyclicality of it markets. He wants to have a contingency plan for the next downturn that involves both defensive and offensive measures. His plans include prudent management of capital and expenses, opportunity to be a buyer or lender of last resort, and to develop cycle proof earnings streams.

Another example of the volatile nature of the business is the company’s quarterly earnings. The worldwide art auction market has two principal selling seasons, which general occur in the second and fourth quarters of the year. The second and fourth quarter net auction sales represented 83 percent of total Net Auction Sales in 2013. Consequently, fist and third quarter results have historically reflected lower revenues when compared to the second and fourth quarters, typically, net losses due to the fixed nature of many of Sotheby’s fixed operating expenses. Plans to extend the brand name to other areas could possibly help reduce or eliminate losses in the off-season.

If a market downturn does happen soon, Sotheby’s is in the financial condition to withstand it just like it did in last recession. The balance sheet is not the greatest, but its score for financial strength is a 7/10. The company has an average debt-to-equity ratio of 0.46 and an interest coverage ratio of 5.21, meaning that they have enough operating income to cover their interest payments 5.21 times.

Another goal of Daniel Loeb (Trades, Portfolio) is to get Sotheby’s operating performance back to its 2007 levels. In 2007 return on equity (ROE) was at 35.29 percent, operating margin was at 30.05 percent, and net margin was at 23.22 percent. For 2013 ROE was 11.41 percent, operating margin was 26.07 percent, and net margin was 15.23 percent. Post-recession, the numbers peak again in 2010, and have been coming down since.

I think that Loeb’s outside perspective will help reinvigorate the board at Sotheby’s. It does not seem to be something that will happen instantaneously, but could help reduce the stock’s downward movement. If the ROE of Sotheby’s were at its previous level of 35 percent, the earnings would be $4.03 per share for the past twelve months. Recently the company earned $2.10 per share for the past twelve months. The latest 10-Q for Q1 2014 listed the total equity of the company at $796,458,000. Third Point put together a slide with their pro forma income statement showing a 2013 EPS of $4.17 with their operating targets in place.

It would be easy to say that the stock should now be worth double since that is where the EPS would be, but that is not the case. I think it will take some time for new changes to be implemented and be added to the bottom line. A signal that change is starting should be if Sotheby’s adds a vision or mission statement to their website. Loeb has said that Sotheby’s needs to define what it is and what it wants to be. Although I think this will pan out for Loeb in the long run, we have gone too far in the cycle, and it seems to be losing steam. The stock in its current condition is valued at $31.12, much lower than today’s closing price of $40.67 (May 9, 2014). To come up with the figure I discounted its earnings back by 12 percent with a growth rate of 10 percent (ROE of 11.41 percent x retention rate of 89 percent). The higher discount rate is due to Sotheby’s high beta. Loeb does add a premium to the stock because of its potential. If I add a 10 percent premium, the stock is valued at $34.23. It could take a couple years for the company to fully develop a new plan. By that time the cycle could be over, but it will be ready to come back strong. Daniel Loeb (Trades, Portfolio)’s track record suggests that he will come out a winner in the long run. According to our Guru Score Board, only David Tepper has had a better record for the past 10 years.

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